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In this issue of Brans Brief:
In the world of pensions, indexation rules, as they are generally called, are becoming increasingly important. One reason is the publication of the Dutch Central Bank’s Indexation Matrix (Indexatiematrix)1 ; another is the general wish to ensure transparency in communications surrounding pension policies, and indexation policies in particular. Pension fund boards are in need of tools to help find the most practical manner to give shape to those policies.
Indexation schemes are often based on the level of funding, which, in light of the forthcoming introduction of the financial assessment framework (Financieel Toetsingskader), is of course determined as the pension fund’s market value. Generally acceptable upper and lower limits are then applied, and the indexation policies are formulated. An example of such an indexation rule is as follows:
Effect of market interest rates
So what is the effect of market interest rates on the rules applied? This is a valid question, considering the assumption in the example set out above that the funding is based on the situation at the end of the financial year. What does this mean in practice?
The easiest way to explain this matter is to consider the funding of an average fund, whose funding is assumed to be 120% at a market interest rate of 4%. The movements in the market interest rate – rounded off – are listed for every month of 2006, showing the funding (and the indexation to be awarded). The figures in the table below are based on the assumption that the value of the share portfolio does not fluctuate
Date |
Market interest |
Funding |
Indexation awarded |
31 December 2005 |
3,75% |
116% |
30% |
31 January 2006 |
4,00% |
120% |
50% |
28 February 2006 |
4,00% |
120% |
50% |
31 March 2006 |
4,25% |
124% |
70% |
30 April 2006 |
4,50% |
128% |
90% |
31 May 2006 |
4,50% |
128% |
90% |
30 June 2006 |
4,75% |
132% |
100% |
31 July 2006 |
4,50% |
128% |
90% |
31 August 2006 |
4,25% |
124% |
70% |
30 September 2006 |
4,25% |
124% |
70% |
31 October 2006 |
4,00% |
120% |
50% |
Movements in the indexation to be awarded
It will be apparent that the interest rate effect can have a great impact on the level of indexation granted. As such, pension fund boards should consider how to determine the level of indexation to be awarded, if the effect of the ‘delusion of the day’ can be avoided (since in practice, the level funding at the end of the financial year is generally used, i.e. a single point of reference).
To illustrate this effect, the graph below shows two types of indexation: one based on the year-end funding and one based on the average level of funding during the past four quarters.
This results in the following developments:
Studies of alternative developments in market interest rates lead to more or less the same conclusion: if the indexation awarded is based on the average of the quarterly funding figures, the indexation will be virtually the same on average but will result in a more even spread over time. Therefore, this prevents major yearly fluctuations in the indexation awarded.
Indexation policies
The question then arises of what indexation policy pension fund boards should apply. Although opinions are undoubtedly divided on this subject, we have demonstrated that there are ways to average the indexation figure over an extended period. However, we realise that this may have certain side effects:
It is possible that the average of the past four quarters results in a higher indexation figure while the level funding at year-end is relatively low. This will cause the pension fund’s financial position to deteriorate further.
However, this problem is also faced by pension funds that do not base their indexation rate on the year-end position but on the level of funding at the end of October, for example.
Conversely, it is also possible that the average over the past four quarters leads to a low indexation figure while the level funding at year-end is relatively high, which is more difficult to explain to the pension fund’s members.
However, this type of policy is based more on a more careful consideration of the assumptions, and does not depend on the delusion of the day. This is a matter to be decided by pension fund boards in defining their indexation policies, given this knowledge and taking into account the desire to balance the interests of all stakeholders.
For more information contact: Michel Stok.
The Work and Income (Capacity for Labour) Act (Wet werk en inkomen naar arbeidsvermogen, or ‘WIA’) provides for two types of benefits: benefits under the Regulations on Income for Fully and Permanently Disabled Workers (Inkomensvoorziening voor volledig en duurzaam arbeidsongeschikten, or ‘IVA’) and under the Regulations on the Resumption of Work by Partially Disabled Workers (Werkhervatting gedeeltelijk arbeidsgeschikten, or ‘WGA’). The Autumn Agreement of 5 November 2004 states that if there are relatively few beneficiaries claiming IVA, the IVA benefits will be increased with retroactive effect and the Premium Differentiation and Market Forces in Occupational Disability Insurance Act (Premiedifferentiatie en marktwerking bij arbeidsongeschiktheidsverzekeringen, or ‘Pemba’) will be abolished. On 20 October, the Minister for Social Affairs and Employment announced that the number of new beneficiaries claiming IVA is indeed relatively small, and that as a result the IVA benefits will be increased retroactively from 1 January 2006 from 70% to 75%. The Pemba will also be abolished.
The raised IVA benefits will affect pension schemes supplementing the statutory disability benefits (disability pensions). For example, an additional 10% in order to ensure benefits of 80% of the recipient’s last maximised wages in the event of disability will cause the provision in the pension scheme to exceed the level of 80%, since the IVA benefits will now be 75%. The relevant provision in the pension scheme may have to be adjusted, depending on how it is worded. We recommend that this be done as quickly as possible, since the increase in the IVA benefits and the abolition of the Pemba will be implemented with retroactive effect from 1 January 2006.
For more information contact: Ingeborg Agema.
On behalf of the staff and partners of Watson Wyatt Brans & Co, we wish to take this opportunity to wish you a merry Christmas, a happy New Year and the best of health in 2007.
We have decided not to send Christmas cards to our relations this year. Instead, the amount we would otherwise have spent has been donated to Stichting Kloppend Hart Voor Rotterdam.
1On 24 November, the Ministry of Social Affairs and Employment published a draft Mark-Up Matrix (Toeslagenmatrix). The present article does not take that Mark-Up Matrix into consideration.
If you have any questions or remarks concerning this issue of the BransBrief, please let us know.
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